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Discover Maintained at Outperform

We are maintaining our Outperform recommendation on Discover Financial Services (DFS - Free Report) based on the consistent increase in its sales volumes along with record-low delinquency and charge-off rates. The company’s strong inorganic growth policy and introduction of home loan products are expected to boost revenues further and diversify the product portfolio.

Discover reported second-quarter 2012 earnings per share of $1.00, a penny ahead of the Zacks Consensus Estimate, but lower than $1.09 recorded in the year-ago quarter. Discover delivered nine quarters straight of positive earnings surprise with an average of 51%.

Discover credit card sales volume reached an all-time high of $100 million in 2011, owing to improved consumer spending and credit quality trends. The trend continued in the first half of 2012, with sales volume of $51.7 billion, up 5.9% year over year, primarily due to increase in the customer base.

In fact, in the third quarter of 2011, Discover’s credit card delinquency rate hit the lowest in 25 years and the charge-off rate fell below 4% for the first time since 2007. Both rates continued to decline in the first half of 2012 as well.

Moreover, the acquisition of Home Loan Center from Tree.com Inc. (TREE - Free Report) has added a residential mortgage component to Discover's direct-to-consumer banking business, thereby enabling it to launch its subsidiary - Discover Home Loans. With the launch of this new unit, Discover now offers commercial and Federal Housing Administration loans with both variable and fixed rates.

However, Discover’s competitors in the credit card business, such MasterCard Inc. (MA - Free Report) and Visa Inc. (V - Free Report) , have substantially larger scales of operation, posing ample risk on the operational front. They not only have relatively stronger global presence and brand names, but they also own exclusive contracts with many financial institutions, thereby limiting Discover’s business opportunities with such institutions.

Further, Discover incurs considerable expenses in order to compete with other credit card issuers to attract and retain customers and increase card usage. Discover’s profits are largely tapered due to the company’s higher-than-expected advertising and marketing expenditures.

Information processing and communications expenses, professional fees, premises and equipment, and other expenses also increased in the first half of 2012, thereby substantially increasing total non-interest expenses. Further, the launch of Discover Home Loans is expected to increase the operating expenses by about $35 million per quarter from the third quarter of 2012.

Nevertheless, the company’s extensive network, sound capital position, stable ratings, rapidly expanding acceptances and cost containment initiatives will help it accentuate earnings over the long term.

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